IRS May Find Decision Interpreting the U.S. Anti-Injunction Act in a Chapter 15 Case Taxing

In our North of the Border Update published yesterday, we wrote that the Ontario Superior Court of Justice confirmed that a Canadian court could order an asset sale by Canadian debtor Grant Forest Products, Inc. (a building materials manufacturer headquartered in Canada with mills in Canada and in the United States), even though the effect of the order would be to convey certain U.S. based assets outside of the “section 363” process. It noted, though, that any objection to the sale of the U.S. assets were to be directed to the United States Bankruptcy Court for the District of Delaware, where the chapter 15 proceeding of Grant Forest Products is currently pending and which court had granted recognition to the CCAA proceeding in the Ontario court as a “foreign main proceeding” under section 1517 of the Bankruptcy Code. The Delaware bankruptcy court in In re Grant Forest Products, Inc., No. 10-11132 (Bankr. D. Del. April 26, 2010) [Docket No. 57] subsequently recognized and enforced the Canadian court’s asset sale order and authorized the asset sale.

Recently, the Delaware bankruptcy court in In re Grant Forest Products, Inc., No. 10-11132, 2010 WL 4780805 (Bankr. D. Del. Nov. 23, 2010) (Walsh, J.), again, was asked to answer another question concerning the scope of the Canadian court’s authority in connection with the sale: Can a Canadian court decide, as part of a Canadian insolvency proceeding, that its court-appointed monitor could file tax returns for United States companies without incurring U.S. tax liability for filing the tax returns? Yes, it can, the Delaware bankruptcy court held; that is, assuming the monitor was not otherwise liable for the tax obligations.

The purchase agreement executed by Grant Forest Products in connection with the asset sale we described in yesterday’s blog entry required Grant Forest Products to file U.S. tax returns for certain of its subsidiaries for the year in which the sale occurred. Although those tax returns had been prepared, they had not been signed and could not be filed, according to the opinion, until January 2011, pursuant to IRS regulations. Because there would likely be no directors or officers available to sign the tax returns after the sale closed, the Ontario court ordered that Ernst & Young, the court-appointed monitor in the Canadian proceeding, could serve as a “Filing Receiver” to sign and file the tax returns without incurring any U.S. tax liability. Like the sale order, the Ontario court order appointing Ernst & Young as the Filing Receiver was contingent on the Delaware bankruptcy court’s approval. The Delaware bankruptcy court approved the Ontario court order naming Ernst & Young as Filing Receiver on May 11, 2010. The sale closed in June 2010; no officers or directors of Grant Forest were available to sign the tax returns.

The U.S. Department of Justice (DOJ) sought reconsideration of the Delaware bankruptcy court order recognizing and enforcing the Ontario court order that permitted Ernst & Young to file the tax returns without incurring any tax liability. The DOJ argued that the order violated a U.S. federal statute, the Anti-Injunction Act, 26 U.S.C. § 7421(a), which permits the U.S. to assess and collect taxes alleged to be due without judicial intervention. The issues were whether the order violated the Anti-Injunction Act and whether the order was appropriate under chapter 15.

It was undisputed that the monitor was not, at the time of the filing of the motion for reconsideration, liable for the subsidiaries’ tax obligations and that the monitor similarly was under no obligation to sign and file the tax returns. Instead, the issue was whether, by signing and filing the tax returns, Ernst & Young could become liable for the subsidiaries’ tax obligations. The DOJ argued that it could, citing Holywell Corp. v. Smith, 503 U.S. 47, 52 (1992), but the bankruptcy court concluded that the DOJ had misinterpreted the Supreme Court decision. It reasoned that the Holywell decision only stood for the proposition that a person obligated to file a tax return must pay any associated tax. Because the monitor was under no obligation to file the tax returns, it had no obligation to pay the taxes and the order shielding the monitor from the subsidiaries’ tax obligations did not violate the Anti-Injunction Act.

The bankruptcy court then turned to the issue of whether the order was appropriate relief under chapter 15. Section 1521(a) of the Bankruptcy Code provides that “[u]pon recognition of a foreign proceeding . . . where necessary to effectuate the purpose of this chapter and to protect the assets of the debtor or the interests of creditors, the court may, at the request of the foreign representative, grant any appropriate relief….” Although section 1521 provides for broad power to effectuate the purposes of chapter 15, there are several provisions of chapter 15 that act as restraints on the broad power provided under section 1521. Section 1522 of the Bankruptcy Code provides that “a court may grant relief . . . under section 1521 . . . only if the interests of the creditors and other interested entities, including the debtor, are sufficiently protected.” Section 1521(d) prohibits a court from “enjoin[ing] a police or regulatory act of a governmental unit.” Section 1506 of the Bankruptcy Code additionally provides that a court may refuse to grant relief if such assistance “would be manifestly contrary to the public policy of the United States.”

The bankruptcy court examined each of these restraints on section 1521(a) relief in turn. It held that the order satisfied the requirements of section 1522 of the Bankruptcy Code because the order would assist in the efficient administration of the cross-border insolvency proceeding and would not harm the interests of the debtors or their creditors. The court also reasoned that the IRS’s interests were not harmed because the IRS may be able to assess and collect taxes from the subsidiaries, their officers and directors, and perhaps, their tax preparer.

Next, the court held that the order did not enjoin a police or regulatory act of a governmental unit under section 1521(d), as argued by the DOJ. Although the IRS is a governmental unit that is able to collect and assess lawfully owed taxes constituting a regulatory act, the court reasoned that because the monitor had no legal obligation to pay the taxes and the order did not enjoin the assessing and collecting of lawfully owed taxes, the order did not violate section 1521(d).

Finally, the bankruptcy court held that the order was not manifestly contrary to public policy under section 1506 of the Bankruptcy Code. The court cited decisions for the proposition that section 1506’s public policy exception should be interpreted narrowly and restricted to only the most fundamental policies of the United States. Although the court recognized that cases decided prior to the enactment of chapter 15 have held that there is a strong public policy in favor of payment of legally required taxes, the court did not need to decide whether tax policy triggers section 1506’s public policy exception because the court reasoned, the order did not concern legally required taxes. The court reiterated that the IRS was still able collect the taxes due (when due) from parties required to pay the taxes, but could not do so from parties not obligated to pay the taxes (the monitor). Therefore, the court held, the order did not implicate the public policy exception in section 1506.

Ultimately, the bankruptcy court denied the DOJ’s motion for reconsideration. Its decision was based on the fact that the monitor who was charged by the Canadian court with signing the debtor’s tax returns was not otherwise legally liable for the taxes. Had Ernst & Young otherwise been liable for the tax obligations, based on the bankruptcy court’s dicta, the bankruptcy court’s decision might have been different.

11 USC Sec. 1517

Sec. 1517. Order granting recognition

(a) Subject to section 1506, after notice and a hearing, an order recognizing a foreign proceeding shall be entered if -

(1) such foreign proceeding for which recognition is sought is a foreign main proceeding or foreign nonmain proceeding within the meaning of section 1502;
(2) the foreign representative applying for recognition is a person or body; and
(3) the petition meets the requirements of section 1515.
(b) Such foreign proceeding shall be recognized -
(1) as a foreign main proceeding if it is pending in thecountry where the debtor has the center of its main interests; or
(2) as a foreign nonmain proceeding if the debtor has an establishment within the meaning of section 1502 in the foreign country where the proceeding is pending.
(c) A petition for recognition of a foreign proceeding shall be decided upon at the earliest possible time. Entry of an order recognizing a foreign proceeding constitutes recognition under this chapter.
(d) The provisions of this subchapter do not prevent modification or termination of recognition if it is shown that the grounds for granting it were fully or partially lacking or have ceased to exist, but in considering such action the court shall give due weight to possible prejudice to parties that have relied upon the order granting recognition. A case under this chapter may be closed in the manner prescribed under section 350.

11 USC Sec. 1521
Sec. 1521. Relief that may be granted upon recognition

(a) Upon recognition of a foreign proceeding, whether main or nonmain, where necessary to effectuate the purpose of this chapter and to protect the assets of the debtor or the interests of the creditors, the court may, at the request of the foreign representative, grant any appropriate relief, including -
(1) staying the commencement or continuation of an individual action or proceeding concerning the debtor's assets, rights, obligations or liabilities to the extent they have not been stayed under section 1520(a);
(2) staying execution against the debtor's assets to the extent it has not been stayed under section 1520(a);
(3) suspending the right to transfer, encumber or otherwise dispose of any assets of the debtor to the extent this right has not been suspended under section 1520(a);
(4) providing for the examination of witnesses, the taking of evidence or the delivery of information concerning the debtor's assets, affairs, rights, obligations or liabilities;
(5) entrusting the administration or realization of all or part of the debtor's assets within the territorial jurisdiction of the United States to the foreign representative or another person, including an examiner, authorized by the court;
(6) extending relief granted under section 1519(a); and
(7) granting any additional relief that may be available to a trustee, except for relief available under sections 522, 544, 545, 547, 548, 550, and 724(a).

11 USC Sec. 1522

Sec. 1522. Protection of creditors and other interested persons
(a) The court may grant relief under section 1519 or 1521, or may modify or terminate relief under subsection (c), only if the interests of the creditors and other interested entities, including the debtor, are sufficiently protected.
(b) The court may subject relief granted under section 1519 or 1521, or the operation of the debtor's business under section 1520(a)(3), to conditions it considers appropriate, including the giving of security or the filing of a bond.
(c) The court may, at the request of the foreign representative or an entity affected by relief granted under section 1519 or 1521, or at its own motion, modify or terminate such relief.
(d) Section 1104(d) shall apply to the appointment of an examiner under this chapter. Any examiner shall comply with the qualification requirements imposed on a trustee by section 322.

11 USC Sec. 1506

Sec. 1506. Public policy exception

Nothing in this chapter prevents the court from refusing to take an action governed by this chapter if the action would be manifestly contrary to the public policy of the United States.